Under its terms of reference the new Office for Budget Responsibility is required to provide updated forecasts for the economy and the public finances at the time of each Budget in order take into account the impact of those measures contained in the Budget. Here we consider those economic forecasts contained in the June 2010 OBR Budget Forecast relating to economic growth. In particular, we consider the OBR’s interpretation of how growth is likely to be affected by the policy measures unveiled by George Osborne in his first Budget as Chancellor of Exchequer on 22 June.

The OBR forecasts that the UK economy will grow by 1.2% in 2010 and by a further 2.3% in 2011. These estimates are lower than those published by the OBR in its Pre-Budget Forecast published on 14 June. The Pre-Budget Forecasts predicted growth of 1.3% in 2010 and 2.6% in 2011. The downward revisions reflect the OBR’s assertion that the Budget’s measures to meet the Government’s fiscal mandate and, hence the resultant fiscal consolidation package, will weaken aggregate demand.

In terms of the components of aggregate demand, the fiscal consolidation will mean restraints on government spending (G) and, if the OBR is right, lower growth in household consumption (C). Lower consumption growth is expected as a result of reduced growth in household incomes and the rise in the standard rate of Value Added Tax next January from 17½% to 20%.

The OBR now forecasts that real household consumption will grow by just 0.2% in 2010, following last year’s contraction of 3.2%, and by 1.3% in 2011. General government final consumption – the Government’s expenditure on current goods and services – is forecast to grow in real terms by 1.7% this year before falling by 1.1% next year. The forecasts for general government capital spending are for a real fall of 4.9% this year, following last year’s rise of 15.7%, followed by a sizeable 19% decline in 2011.

A more positive note emerging from the OBR forecasts relates to capital expenditure by businesses. The measures to reform corporation tax, which include a reduction in the main rate of corporation tax from 28 per cent to 24 per cent over four years beginning with a one per cent reduction from April 2011, are predicted to have a favourable effect on investment. Business investment is forecast to rise in real terms by 1.4% this year, following last year’s fall of 19.3%, and to rise again in 2011 by 8.1%.

The projections for growth from 2013 are now stronger than in the OBR’s Pre-Budget Forecast with the economy portrayed as adjusting more quickly at this point towards its potential output. Potential output is the level of output level when the economy’s resources are operating at ‘normal capacity utilisation’. But, in 2015, which is at the end of the OBR’s five year forecast period, the UK economy is still forecast to be experiencing a negative output gap. In other words, actual output will still be less than potential output.

To help paint a picture of how the economy’s output will adjust towards its potential level consider the OBR estimates for the output gap. The OBR estimates that in financial year 2009-10 the economy’s output was 4.1% below its potential. This negative output gap is now expected to be reduced to 3.7% of potential output in 2010-11, to 2.8% in 2012-13 and to 0.9% of potential output in 2015-16.

Questions

What do you understand by the concept of aggregate demand?

What are the component expenditures of aggregate demand? Which of these do you think is the largest in value terms?

The OBR is forecasting the household sector’s disposable income to grow in real terms this year by 0.2% and by 1.2% next year. Why then is the OBR identifying weaker consumer demand as a result of the Budget measures as a major reason for revising down its predictions for economic growth?

The OBR argues that the fiscal consolidation measures will have a ‘direct effect’ on household incomes and so on spending, but that this will be ‘partially offset by a decline in saving’. Why might the OBR be arguing that a fiscal consolidation will lead to a decline in saving? Evaluate the OBR’s arguments.

What do you understand by the concept of an output gap? What does a negative output gap signify?

To see the sorts of problems that forecasters commonly face, try identifying reasons why the output gap could be eliminated more quickly or less quickly as a result of the Budget measures.